At the time of
the 1993 Consultation, Herman Daly was a Senior Economist at The World Bank.The
views here presented are those of the author and should in no way be attributed to the
World Bank. This text first appeared in R. Constanza, ed. 1991. Ecological Economics:
The Science and Management of Sustainability. New York: Columbia University Press,
used with permission of the author.Section headings:

ABSTRACT: Environmental economics is traditionally
treated as a subdivision of microeconomics. The focus is on getting prices right for
optimal allocation. It is argued that in addition there is a neglected macroeconomic
question, that of optimal scale, that is independent of optimal allocation, and must be
served by an independent policy instrument. The issue of optimal scale, reasons for its
neglect, definition, and policy implication are discussed.

Environmental economics, as it is taught in
universities and practiced in government agencies and development banks, is overwhelmingly
microeconomics. The theoretical focus is on prices, and the big issue is how to
internalize external environmental costs to arrive at prices that reflect full social
marginal opportunity costs. Once prices are right, the environmental problem is
"solved" -- there is no macroeconomic dimension. Cost/benefit analysis in its
various permutations is the major tool for estimating full-cost prices. So in practice as
well as theory we remain within the domain of microeconomics. There are, of course, good
reasons for environmental economics to be closely tied to microeconomics and it is not my
intention to argue against that connection. Rather, I ask if there is not a neglected
connection between the environment and macroeconomics.

A search through the indexes of
three leading textbooks in macroeconomics reveals no entries under any of the following
subjects: environment, natural resources, pollution, depletion. One of the three
does have an entry under "resources," but the discussion refers only to labor
and capital, which, along with efficiency, are listed as the causes of growth in
GNP. [N.B. See the following: R. Dornbusch and S. Fischer, Macroeconomics,
4th ed. (New York: McGraw-Hill, 1987); R. E. Hall and J. B. Taylor, Macroeconomics,
2nd ed. (New York: W. W. Norton, 1988); R. J. Barrow, Macroeconomics, 2nd ed. (New
York: Wiley and Sons, 1987).]
Natural resources are not mentioned. Evidently GNP growth is thought to be independent of
natural resources. Is it really the case, as prominent textbook writers seem to think,
that macroeconomics has nothing to do with the environment? What historically has impeded
the development of an environmental macroeconomics? If there is no such thing as
environmental macroeconomics, should there be? Do parts of it already exist? What needs to
be added? What policy implications are visible?

The reason that environmental
macroeconomics is an empty box lies in what Thomas Kuhn calls a "paradigm," and
what Joseph Schumpeter more descriptively called a "preanalytic vision"
(Schumpeter 1954). As Schumpeter emphasized, analysis has to start somewhere -- there has
to be something to analyze. That something is given by a preanalytic cognitive act that
Schumpeter called "vision." One might say that vision is what the "right
brain" supplies to the "left brain" for analysis. Whatever is omitted from
the preanalytic vision cannot be recaptured by subsequent analysis. Schumpeter is worth
quoting at length on this point:

"In practice we all start our own research from
the work of our predecessors, that is, we hardly ever start from scratch. But suppose we
did start from scratch, what are the steps we should have to take? Obviously, in order to
be able to posit to ourselves any problems at all, we should first have to visualize a
distinct set of coherent phenomena as a worthwhile object of our analytic effort. In other
words, analytic effort is of necessity preceded by a preanalytic cognitive act that
supplies the raw material for the analytic effort. In this book, this preanalytic
cognitive act will be called Vision. It is interesting to note that vision of this kind
not only must precede historically the emergence of analytic effort in any field, but also
may re-enter the history of ever established science each time somebody teaches us to see
things in a light of which the source is not to be found in the facts, methods, and
results of the pre-existing state of the science."

The vision of modern economics in general, and
especially of macroeconomics, is the familiar circular flow diagram. The macroeconomy is
seen as an isolated system (i.e., no exchanges of matter or energy with its environment)
in which exchange value circulates between firms and households in a closed loop. What is
"flowing in a circle" is variously referred to as production or consumption, but
these have physical dimensions. The circular flow does not refer to materials recycling,
which in any case could not be a completely closed loop, and of course would require
energy which cannot be recycled at all. What is truly flowing in a circle can only be
abstract exchange value -- exchange value abstracted from the physical dimensions of the
goods and factors that are exchanged. Since an isolated system of abstract exchange value
flowing in a circle has no dependence on an environment, there can be no problem of
natural resource depletion, nor environmental pollution, nor any dependence of the
macroeconomy on natural services, or indeed on anything at all outside itself (Daly 1985).

Since analysis cannot supply what the preanalytic
vision omits, it is only to be expected that macroeconomics texts would be silent on
environment, natural resources, depletion and pollution. It is as if the preanalytic
vision that biologists had of animals recognized only the circulatory system, and
abstracted completely from the digestive tract. A biology textbook's index would then
contain no entry under "assimilation" or "liver. The dependence of the
animal on its environment would not be evident. It would appear as a perpetual motion
machine.

Things are no better when we turn to the advanced
chapters at the end of most macroeconomics texts, where the topic is growth theory. True
to the preanalytic vision the aggregate production is written as Y = f(K,L), i.e., output
is a function of capital and labor stocks. Resource flows (R) do not even enter! Nor is
any waste output flow noted. And if occasionally R is stuck in the function along with R
and L it makes little difference since the production function is almost always a
multiplicative form, such as Cobb-Douglas, in which R can approach zero with Y constant if
only we increase K or L in a compensatory fashion. Resources are seen as
"necessary" for production, but the amount required can be as little as one
likes!

What is needed is not ever more refined analysis of
a faulty vision, but a new vision. This does not mean that everything built on the old
vision will necessarily have to be scrapped, but fundamental changes are likely when the
preanalytic vision is altered. The necessary change in the vision is to picture the
macroeconomy as an open subsystem of the finite natural ecosystem (environment), and not
as an isolated circular flow of abstract exchange value, unconstrained by mass balance,
entropy and finitude. The circular flow of exchange value is a useful abstraction for some
purposes. It highlights issues of aggregate demand, unemployment and inflation that were
of interest to Keynes in his analysis of the Great Depression. But it casts an
impenetrable shadow on all physical relationships between the macroeconomy and the
environment. For Keynes, this shadow was not very important, but for us it is. Just as,
for Keynes, Say's Law and the impossibility of a general glut cast an impenetrable shadow
over the problem of the Great Depression, so now the very Keynesian categories that were
revolutionary in their time are obstructing the analysis of the major problem of our time.
Namely, what is the proper scale of the macroeconomy relative to the ecosystem?

Once the macroeconomy is seen as an open subsystem,
rather than an isolated system, the issue of its relation to its parent system (the
environment) cannot be avoided. The obvious question is, how big should the subsystem be
relative to the overall system?